Chapter 7

Money, Inflation & Welfare

2

Learning Outcomes➢ Real Vs. nominal interest rates – Fisher equation

➢Neutrality Vs. Superneutrality - IS-LM framework

➢ The welfare costs of inflation – Friedman quantity theory of

Money

➢ Inflation as taxation

➢ Hyperinflation - Cagan Model

➢ Very high, non-explosive inflation – Dornbusch Model

3

7.1 R Vs. r

Ch 7– Money, inflation and Welfare

Key Definitions

▪ Nominal interest rate – The money return an individual earns on an

investment.

▪ Real interest rate – Represents the return to individuals on an investment in

terms of the goods and services that can be purchased

4

7.2 Fisher equation

Ch 7– Money, inflation and Welfare

Theoretical definition =>

Ex ante real interest rate =>

Ex post real interest rate =>

5

7.3 Neutrality Vs. Superneutrality

Ch 7– Money, inflation and Welfare

Key concepts

▪ Neutrality

– A rise in the steady growth rate of the money stock is said to lead to an

identical rise in the steady growth rate of prices.

- As a result real output remains unchanged

- All real balances in an economy are independent of the quantity of money

- Real variables unaffected by the level of money supply

- This is typically a long term concept

6

7.3 Neutrality Vs. Superneutrality

Ch 7– Money, inflation and Welfare

Key concepts

▪ Superneutrality

- Money is said to be superneutral, if changes in the growth rate of the

money supply exert no effects on output.

- When inflation is fully anticipated, the real interest rate is independent of

it. Ie: Nominal interest rate adjusts in the same proportion

- Real Variables unaffected by the level and rate of money supply growth

- i.e economic activity is independent of money growth.

7

7.4 Implications for IS-LM framework

Ch 7– Money, inflation and Welfare

Setup

▪ Consumption depends positively on disposable income and negatively on the

real interest rate

8

7.4 Implications for IS-LM framework

Ch 7– Money, inflation and Welfare

Graph - Superneutrality

Results

▪ nominal rate, Rt, must adjust one-for-one with changes in the inflation rate

9

7.4 Implications for IS-LM framework

Ch 7– Money, inflation and Welfare

Key Results

▪ Real interest rate unchanged

▪ Output unchanged

▪ nominal rate, Rt, must adjust one-for-one with changes in the inflation rate

▪ Even with fully anticipated inflation, welfare costs exist as nominal interest

rates and quantity of money is affected

Money is both Neutral & Superneutral

10

7.4 Implications for IS-LM framework

Ch 7– Money, inflation and Welfare

Setup

▪ There is a positive relationship between real money balances and income

▪ In this model while real interest rates remain unchanged, both nominal

interest rates and real money balances are impacted

11

7.4 Implications for IS-LM framework

Ch 7– Money, inflation and Welfare

Graph – Non- superneutrality

12

7.4 Implications for IS-LM framework

Ch 7– Money, inflation and Welfare

Key Results

▪ Real interest rates lower

▪ Output unchanged

▪ There will be less than a one-to-one rise in the nominal interest

▪ Since real balances are affected, price levels have welfare implications

Money is Neutral but not Superneutral

13

7.5 The cost of inflation and welfare

Ch 7– Money, inflation and Welfare

“What a government spends the public pays for”

- Keynes on Inflation taxes

14

7.5 The welfare costs of Inflation

Ch 7– Money, inflation and Welfare

Seignorage & inflation tax

Seignorage – The ability of the government to acquire real resources at no cost

through the process of money printing

15

7.5 The welfare costs of Inflation

Ch 7– Money, inflation and Welfare

Money printing as an inflation tax

The welfare cost of fully anticipated inflation arises because inflation raises

the nominal interest rate, reducing the demand for real money balances and

therefore reducing the utility obtained from the use of money.

16

Cost Vs Value of CurrencySri Lankans leave so many coins in India that the central bank is running out

▪ Nearly 20 tonnes (22 tons) of Sri Lankan coins are laying unused in Buddhist temples inIndia,

▪ Religious pilgrims leave them in temples as offerings, and drivers also keep blessedcoins in their cars for good fortune.

▪ The government says an additional 2 billion coins are in people’s homes, tucked awayin drawers and saving tills.

Read More: Quartz

Ch 7– Money, inflation and Welfare

17

Cost Vs Value of CurrencyCoin jewelry

Ch 7– Money, inflation and Welfare

Central bank Currency museum

18

7.5 The welfare costs of Inflation

Ch 7– Money, inflation and Welfare

Welfare cost of Money

Welfare cost = Loss of consumer surplus + Lost seignorage revenue

Efficiency of inflation tax =>

The more inelastic the demand for money, the more inefficient is inflation as a

form of taxation.

19

7.6 Hyperinflation

Ch 7– Money, inflation and Welfare

A period of very rapid and rapidly accelerating inflation leading to astronomical

prices

Most often triggered due to political instability such as when the government is

unable to finance its expenditure except through money creation.

20

7.6 Commodity money & hyperinflation

▪ Changes in public confidence in a government issuing fiat money may be

enough to make the fiat currency worthless.

▪ Commodity money, however, retains value based on the metal or other

material content it has.

▪ But it runs a greater risk of large price fluctuations based on changing

commodity prices.

▪

21

7.6 Hyperinflation of Commodity money

The onion Knight dealing with inflation - Game of Thrones Season 7 Episode 5

22

7.6 Hyperinflation

Ch 7– Money, inflation and Welfare

Cagan (1956) model of inflation

23

7.6 Hyperinflation

Ch 7– Money, inflation and Welfare

Key Result

▪ Inflation is a function of money growth and expected future inflation

▪ Expectations of higher future inflation leads to current inflation to

increase above money growth

High expected inflation leads to higher current inflation – Self-fulfilling

prophecy

24

Mary Poppins & Banking Crisis

Ch 7– Money, inflation and Welfare

https://www.youtube.com/watch?v=C6DGs3qjRwQ

A Spoonful of doubts makes the Bank go down..

25

Similar situation in stocks..

Ch 7– Money, inflation and Welfare

26

7.7 High, non-explosive inflation

Ch 7– Money, inflation and Welfare

▪ Can be explained in terms of a continuing but non-deteriorating government

deficit

27

7.7 High, non-explosive inflation

Ch 7– Money, inflation and Welfare

Dornbusch model – Setup

▪ The governments tax revenue falls sort of its expenditure by a fixed proportion

of nominal income = g

▪ The government has a poor credit rating and is unable to borrow from the

capital markets so this deficit can be financed only through the creation of

money.

28

7.7 High, non-explosive inflation

Ch 7– Money, inflation and Welfare

Dornbusch model – Key results

▪ For large values of g and/or V the inflation rate can be quite rapid, but in the

simplest versions of this model there is no reason why it should accelerate.

29

7.8 Learning Outcomes

30

7.8 Extended activity & Sample exam

questions

31Ch 2– Nature of Money

Further Reading

Articles

• Fallacy of Superneutrality – Link